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Author: WendyBG Big gold star, 5000 posts Top Favorite Fools Top Recommended Fools Feste Award Winner! Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35510  
Subject: Re: Bonds Date: 4/2/2006 1:46 PM
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<The main reason I am interested in this matter is that my father is going to be retiring soon and is possibly looking for a portfolio with less risk....
If one is well educated in bonds, can you expect to beat bond funds, or are bond funds the way to go? >

I didn't think that any of the posts, so far, answered your father's primary need: safety of principal, in retirement.

A retired person needs to protect his/her nest egg (I am 53, recently retired). Therefore, it's important to know what return is necessary, to cover the retiree's needs. If the retiree's needs can be met, without taking on risk, then attempting to beat a benchmark (say, a bond fund index), and taking on extra risk to get higher returns is a dangerous, unnecessary action. Many articles have discussed how retirees are moving into higher-risk investments, to generate income, in a low-interest rate environment. This is dangerous.

If a retiree takes on risk, and loses principal, early in retirement, the money may run out before the retiree's life runs out. If that happens, your dad may be forced back to work...or you may be forced to help support him. Think carefully about that, before giving him advice.

To get a good retirement calculator, which uses a Monte Carlo calculation to show the probability of different portfolios meeting a retiree's needs, see the retirement area of www.fidelity.com.

Back to bonds:
In a nutshell:
The price of a bond moves inversely to prevailing interest rates.

If you buy a bond, and hold it to maturity (or call), you will receive the coupon interest, plus the par value. There is no risk to principal, in holding a bond to maturity.

If you are forced to sell the bond, before it matures, you will not receive the price you paid for it, unless interest rates have not changed (unlikely). If interest rates rise, you will receive less than you paid for it. The longer the time to maturity, the greater the drop in value.

However, the choice of whether to sell the bond is yours. You can decide to hold it to maturity, and raise money another way.

Bond funds are qualitatively different. Bond fund managers trade bonds constantly. You buy a share of a bond fund, at a particular price (the Net Asset Value, or NAV). You are not in control of the trades of the bond fund.

Because the bond fund holds many bonds, which are constantly traded, the bond fund does not have a maturity date. If interest rates rise, the NAV of the fund will drop.

All bond funds have a duration, in years (this is a complicated calculation of the dates to maturity of all the bonds in the portfolio -- kind of a weighted average). The duration is listed in the prospectus. In a rising interest rate environment, the NAV will fall, but the interest earned by the bond fund will rise. Eventually, you will make enough interest, to make up for the fall of the NAV. The duration of the fund will tell you about how long this will take. Short term funds are much less volatile than long term funds.

The other thing to take into account is inflation. Here is a chart of real bond rates (interest rate minus inflation), over decades. If you buy a long bond, and inflation rises (likely, since the government is spending on guns and butter, like it did in the early 1970s), you can be stuck with a negative real interest rate. I met people in the late 1970s in this unenviable position. To mitigate this risk, an investor can buy inflation-adjusted bonds, such as TIPS. (This may not keep up with a retiree's personal rate of inflation, since the CPI-U underweights expenses that are critical to retirees, such as health insurance.)

http://www.martincapital.com/chart-pgs/CH_mmnry.HTM

I think that this information is more relevant to your Dad, than a lot of theory. If a kid (with little historical background in the vagaries of bonds) told me to invest my retirement nest egg in a bond fund, or in higher-yielding bonds (at a time when risk premia are at historic lows), and I lost my retirement nest egg, I wouldn't be too happy!

At a family reunion, I met a cousin, and his girl friend, both in their late 20s, who both work at the bond desk of a major brokerage. Neither of them had a clue about past inflation, business cycles, or any other type of history that could affect the value of bonds. Before giving advice, better know the risks.

Wendy
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